Americans Win Economics Nobel for Market Insights

Scholars Fama, Hansen and Shiller Share Award

University of Chicago Professor Eugene Fama is widely recognized as the "father of modern finance." On Monday he was one of three Americans to win the Nobel Prize for Economics. Fama joins the News Hub.

By

Brenda Cronin

Updated Oct. 14, 2013 7:49 p.m. ET

Three American scholars won the Nobel Prize in economics for pioneering work in financial markets that has transformed portfolio management and asset pricing and launched the study of how emotions affect investment decisions.

The Royal Swedish Academy of Sciences on Monday honored Eugene Fama and Lars Peter Hansen of the University of Chicago and Robert Shiller of Yale University, citing their complementary but independent breakthroughs on "empirical analysis of asset prices."

The laureates focused on how prices are set for stocks and bonds, but their findings have implications far beyond financial markets. Every corner of the macroeconomy is affected by the risk tolerance—as well as rational and irrational acts—that spur individuals and corporations to invest or save.

"Nobody's scratching their heads over this one. They've all been on the short list for many years," said Mark Gertler, a New York University economist currently on sabbatical at Columbia University. "The interesting thing is how the three are connected."

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The 74-year-old Mr. Fama is seen by many as the father of modern finance, for his 1960s-era work on the theory of efficient markets. After meeting with little success in stock picking, Mr. Fama found that markets were efficient in a day-to-day or month-to-month time frame. They absorbed the latest information swiftly and seamlessly and yielded accurate asset prices. The conclusion upended notions of trying to profit from timing the market or stock picking—and gave rise to the index-funds industry.

Twenty years later, Mr. Shiller found that markets' short-term efficiency was less enduring over longer periods. He examined why asset prices were too volatile to be justified by fundamental information, such as dividends. In spans of three to five years, prices moved for a host of reasons, such as investors' risk aversion—or their optimism or pessimism. The field of behavioral economics was born as scholars attempted to tease out what was behind investors' shifting risk tolerances and decisions.

Nobel Prize Winners

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At the same time, Mr. Hansen was working on questions about market predictability, and came up with a tool for studying changes in asset pricing. That led to his Generalized Method of Moments—an econometric tool that today is a standard economics theorem, applicable throughout the field and not just to financial markets.

Mr. Hansen's theorem is "absolutely spectacular," said John Cochrane, a professor at the University of Chicago Booth School of Business. "It looks really complicated but he's kind of taken it to another dimension…and seen how gloriously simple it is."

At 60, Mr. Hansen is the youngest of Monday's winners. "I've been feeling old recently," he said. "But this gives me the feeling of being young." He said his work on the theorem dates back to when he was a graduate student and starting out as a professor—and being mentored by 2011 Nobelists Thomas Sargent and Christopher Sims.

Mr. Cochrane, who is Mr. Fama's son-in-law as well as his colleague, said Monday that after hearing from the Nobel prize panel, his father-in-law resumed his regular routine, teaching a class Monday at Chicago, his professional home of 54 years. Although Mr. Fama has exchanged tennis and windsurfing for golf, he doesn't show any signs of slowing his pace, Mr. Cochrane said.

ENLARGE

Robert Shiller found some predictability in stock and bond prices over the longer term, in part due to risk tolerance and behavioral biases.
Reuters

ENLARGE

Lars Peter Hansen, left, developed a statistical method to test rational theories of how assets are priced that became a standard of econometrics. Eugene Fama put forth the 'efficient market' hypothesis that says markets, taking the latest and best data, come up with the best prices for assets.
Reuters

Mr. Shiller, 67, is one of the creators of the Standard & Poor's/Case-Shiller Home Price Index, which tracks changes in residential values across the U.S. He is working on a book with George Akerlof, who shared the 2001 Nobel, to be titled "Phishing for Phools," about manipulation and deception in economics, Mr. Shiller said. Messrs. Shiller and Akerlof co-wrote "Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism."

Mr. Shiller, who has kept a diary since the age of 12, said in January he plans to teach a free online introductory course on financial markets through Coursera. There will be some emphasis on behavioral finance in the class, he said.

Mr. Shiller said that after being notified early Monday by the prize committee, he called his brother in his hometown of Detroit, where the Nobel announcement evidently hadn't spread. "Did you hear the news?" he asked. His brother replied, "The Tigers lost," referring to the Boston Red Sox come-from-behind win Sunday night.

"The 74-year-old Mr. Fama is seen by many as the father of modern finance, for his 1960s-era work on the theory of efficient markets. After meeting with little success in stock picking, Mr. Fama found that markets were efficient in a day-to-day or month-to-month time frame. They absorbed the latest information swiftly and seamlessly and yielded accurate asset prices."

how to measure accuracy? i wonder if the theory is useful for more than a month. i have not sold stocks in years.

"The conclusion upended notions of trying to profit from timing the market or stock picking—and gave rise to the index-funds industry."

upended? i think not. whole industries continue to exist for the purpose of asset picking. apparently few people listen to--or understand--nobel prize winners.

Were any of them NOT blindsided by the onset of the crisis almost six years ago? Did any of them predict an era of frugality and protracted unemployment? If not, then they didn't put together the right kind of theory. According to an earlier commenter, Shiller did correctly foresee the market behavior in 2000 and 2008, so I give him kudos for that.

The modern corrupt network of government, academics, media and corporations which came close to destroying the world financial system [2008] is well explained in 'Predator Nation.' 2012 by Charles H. Ferguson.

'This Town' describes the Washington end of the US power structure, and its profitable revolving door.

In both works, a figure of roughly $1 million a year seems an average for high ranking economists or politicians moving to the corporate world. These two groups often rub shoulders on corporate boards, high pay for limited work.

'Laura D'Andrea Tyson (born June 28, 1947) is an American economist and former Chair of the US President's Council of Economic Advisers during the Clinton Administration. She also served as Director of the National Economic Council. She is currently a professor at the Haas School of Business of the University of California, Berkeley.' [Wikipedia]

Not especially known for corruption, in 2011 she had four corporate directorships that paid her $784K a year. Other income not required to be stated by Berkeley. I remember she wrote an editorial for increasing H1-B quotas in the last attempt to do so, probably 2007, that was pure industry talking points.

Could economists' opinions possibly be affected by their outside income?

The great trend for decades has been globalization. H1-B high tech visas help US corporations move American jobs and technology to low wage countries. You'll have to look hard for a name brand economist who criticizes H1-B. These economists typically make upwards of $1 million a year from corporate sources, and would be loath to alienate their corporate patrons. Virtually no one in the groupthink American establishment criticizes H1-B, lest they tarnish their personal brand and be labeled xenophobic.

Three long over-due Nobels. It's especially gratifying to see Fama win after all the undeserved opprobrium heaped on the efficient capital markets hypothesis over the years. The ECMH made a ground-breaking contribution to the study of how information is absorbed by securities markets that has yet to be matched by any of the later theories.

USA a great nation.Its heaven on earth But New convert to islam soon will turn this into hell. As followers don't believe in building but destruction.Just learn from 60 islamic nation what you se will get. Obama is on eof them.

Wow, did they support Obama? Not to denigrate the hard work of these men, but the prize has become somewhat of a punch line after it gave Obama the peace prize for having achieved nothing other than progressive street cred.

Now I can always say that my finance prof at Chicago was a Nobel prize winner....I had Fama way back when, and it was a tough course but one that really made you think (and work)..Congratulations to the three of you!

Fama teaches a course at the U of Chicago Graduate School of Business that is called "turbo finance". After a few weeks, if you don't impress him in the class by demonstrating acute and articulate participation, he "invites" you to drop out.He spoke at my commencement. Sharp guy . . .

I know these are brilliant and undoubtedly deserve the Nobel Prize, BUT I think that our government started getting deeply in debt when it started paying attention to what economists had to say. Every time the federal government implements one of these theories, another entitlement program gets started that becomes politically impossible to stop.

I am in asset management but greatly respect Prof Fama's work...despite all the marketing from asset managers, truth is that markets are pretty much efficient and growth in passives are a living example of why his assertion is largely correct !

Prof. Fama's work in academia was brought into the real world over many years by student David Booth (founder of DFA), who in gratitude donated $300MM to University of Chicago's graduate business school.

George Stigler and Milton Friedman are looking down from somewhere today with great pride! Go Fama!!!

This prize really should be stopped..the keynsians have failed time and again..markets are efficient only when they are not distorted by govts/central banks which never occurs...especially a equity market is about as far from efficient as you can get..

In evaluating the "Strong Version" of the Efficient Market Hypothesis, please remember what Sir Issac Newton so famously stated when he lost a small fortune investing in the South Sea Bubble: "I can calculate the movement of the stars, but not the madness of men". There is a big difference between Physical Science and the Markets, wherein the latter are subject to Human emotion. All the "Quants" in the World cannot properly calculate that factor.

Glad to hear Gene Fama finally got his Nobel! He was a great teacher despite my rather poor grade (the math required was very tough for an English major in undergrad). I barely squeaked by with a passing grade and it was the hardest class I ever took, but I was prouder of that grade than any A I ever got.

That tells me that 80% of the world's best research is still done in USA and the whole world benfits greatly from great research framework and environment existing in USA besides the best place still to attract best of the minds. May it remain that way forever.

It was Shiller who way back in the middle of 2004 wrote an op-ed piece for this newspaper saying Folks we Have a Housing Bubble and that unwinding it would be Very Painful. This when Bernanke and other mainstream economists denied both the Housing Bubble and the very concept that their could even be a housing bubble. Doesn't give me much confidence in the Federal Reserve or government economists.

Special WooHoo... shout out for Prof Shiller. Have been a follower of Prof Shiller's writings since 2001. Personally I and familly saved a ton after reading Irrational Exuberance (both editions). Huge huge thank you to Prof Shiller. Very happy to see him honored with this Prize.

Mr. Bishop: You would enjoy reading "The Unbeatable Market: Taking the Indexing Path to Peace of Mind" By Professor Ron Ross.

There is something in human nature that makes people want to "beat the odds". And, to most people, active management seems far more promising than a passive approach. And, active managers have such great P.R. and so much money to spend on publicity and entertainment . . . it's a good sell.

There are pension consulting firms and investment consulting firms which maintain databases of large populations of professional asset management firm's investment performance The databases are composed of firms with very well educated and well trained professional managers who manage assets for mutual funds, pension plans, endowment funds, employee benefit trusts and personal trust funds.

These databases are used to calculate, measure, and compare manager performance. The owners of the databases - Wilshire Associates, SEI, Financial Services, Russell Consulting, The Trust Universe Comparison Service, and others - constantly compare the results out-put from their database to all the other databases and try to refine the process by explaining any differences and correcting for errors.

These databases confirm that, for longer periods of time (about eight years), under a variety of market conditions, broad based passively managed indexes outperform average returns of all active managers. Many commenters have opined that active managers' management fees and their soft dollar brokerage costs (index funds don't use soft dollars) are reasons index fund excess performance (these costs reduce the compounding of asset values).

Robert Kirby, who was the highly respected Chief Investment Officer at Capital Guardian Group used to say, 'selecting an asset manager is the riskiest thing a professional asset custodian does.' (Because, one is selecting from a group in which over half the managers under perform in the longer run). Darts anyone?

Not really Mike. Maybe markets would be efficient, but for missaligned incentives. AIG bosses cared about their best interest, not AIG's interest. That is how they pushed so many CDS' without adequate capital. These guys are still multi millionaires, while AIG shareholders have been wiped out.

1 over the current PE ratio plus the current dividend yield of the S&P 500 is a good measure to predict returns for the coming decade. Right now, it looks like stocks should return 6% for the buy and hold index fund investor over the next 10 years. That's over the long term. Tomorrow, next month, next year, stocks could do any thing. Of course, there is a specualtive element that cannot be predicted.

John Bogle's "Commomn Sense on Mutual Funds" does a great job of backtracking this calculation.

Unless you buy stocks for dividends..it really becomes a great fool theory..and with a central bank distorting rates..I would hesitate to invest even in a diversified portfolio at this point with a currency crisis around the corner..

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